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Call Me Starbucks

Bill Mann looks at Starbucks for a Rule Maker investment.

The bargains are everywhere and the Rule Makers are loaded for bear. We've taken a look at some financial companies in the last few columns and now we're gonna look at the leading purveyor of the second-most popular beverage in the world by volume consumed: coffee.

Yes, the Rule Maker is going to look at Starbucks(Nasdaq: SBUX). This is a company that has dropped in price by some 40% this year, not as much as other companies, but heck, Starbucks is a) a real business, b) relatively unencumbered by debt, and c) growing at a pretty healthy clip. Over the past year the company has added more than 1200 stores, equaling almost 30% of the total number of outlets. Where Starbucks' international presence was limited to a few outlets in Vancouver before 1996, it now has 880 international stores, and is enjoying accelerating growth overseas.

All of this is great. It's in fact the thing that attracted the Rule Breaker Portfolio. Let's take it as a given that Starbucks is a great company, with great fundamentals. And I really don't want to hear anything from people who are torqued off at Starbucks because one employee chose to charge an ambulance crew for water in downtown New York in the first hours after the terrorist attacks on the World Trade Center. That was a boneheaded thing for that employee to do, of course, but the company responded to it and has, on the balance, been one of the good guys in supporting those who are working on the recovery efforts in New York and at the Pentagon.

What I want to know is whether or not Starbucks is a good investment, right here, right now. After all, on a straight price-to-earnings basis, it's still quite pricey at a multiple of 46. That calls for quite a bit of top-line growth over an extended period of time. I'm inclined to believe that it is possible.

Starbucks breaks itself into several units: North American Retail (NAR), which consists of the 3700 stores open in the United States and Canada, is the largest; Business Alliances, the unit that sells Starbucks branded products to companies and services; and other units including international, wholesale, and licensing. As of Starbucks' most recent 10-Q the revenue for each segment broke down thusly:

The "other business units" segment shows the most rapid growth, coming in at 41% over the same nine months the previous year. A portion of this growth has been seen overseas, where Starbucks continues to add the highest percentage of stores. In the U.S. there is still plenty of room for growth. This may be hard to believe in some of the Starbucks-saturated towns such as New York or San Francisco, but there are no Starbucks in Omaha, for example. Which is pretty near criminal -- talk about a town that could use a jolt of caffeine.

Ahem. Starbucks is still in a rapid growth mode, having doubled its outlet count in the past two years. Starbucks' long-standing policy has been for the company to own the stores outright rather than to franchise them, thus there is minimal mitigating effect of a franchise fee to balance out the capital costs required to open a new store.

They pull in big bucks. How much do they make?This means that a straight P/E is going to be an overstatement of the company's performance due to enormous capital expenditures. A look at the cash flow statement bears this out: Income from operations was $339 million for the first 39 weeks of this year, but capital expenditures chewed up $255 million of that. So, if we annualize these amounts, we have annual cash flows of $452 million and $339 million and free cash flow of $113 million. Given an enterprise value of $5 billion, that equals an enormous ratio of price-to-free cash flow of 44.

Ah, but as we stated earlier, Starbucks is still growing very rapidly, and it has been able to finance almost all of this growth from cash produced by the company's operations. So here is the question: Is Starbucks creating value with those dollars that it is reinvesting, or is it just growing for the sake of growth?

Let's use a rough cut Return on Invested Capital (ROIC) calculation to do this. Guest-columnist Andrew Chan wrote an erudite Fool on the Hill column on ROIC if you are interested in learning more about how to calculate it. Unfortunately, ROIC is one of those functions that becomes hopelessly complex in the execution, so we're looking for a "roughly right" number on the conservative side, not precision. In this case, I come up with a ROIC of 26.1%, which means that for every dollar of cash reinvested, it is annually creating $0.26 in return. This means that for each new outlet Starbucks is opening, it takes less than four years for the company to gain back all of the costs associated with it.

So the question thus becomes: Do we pay a huge multiple to gain that potential cash return? I think the answer comes in two portions. First, Starbucks is doing exactly what it is supposed to: growing its business profitably. Thus I have no problem at all with the company retaining and reinvesting all of its capital. Second, at some point, Starbucks is going to bounce up against growth restraints. Its expansion in the Middle East is brilliant, as is its expansion in East Asia: both are significant coffee and tea consuming regions. But we really have no idea what Starbucks management would do in a slower growth environment. Would it continue to plow money into other ventures, or start to return it to shareholders? Given the level of risk associated with the company's price at this point, I think that the answer for an investment in Starbucks is "at a certain price that is still lower than it currently stands."

Fool on!Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann's doctor ordered him to drink more coffee. Bill likes his doctor. Bill owned no companies mentioned in this article at time of publishing. The Motley Fool is investors writing for investors.